January 2011 Archive for Know Your Market

If January’s volatility has shaken your confidence, you don’t have to spend the entire year feeling that way. Take steps to seize some control and build your best possible weighted average price for 2011.

By Steven Schalla, Stewart-Peterson

The dairy markets roared into 2011 with action that helped bring about the strongest four-week upward move in Class III prices since April 2007.

There’s an old saying on Wall Street, “As goes January, so goes the year.” Will that hold true for the dairy markets? Let’s take a look at what happened, and what might be ahead for us in dairy.

After the collapse of cheese prices mid-December, cheese buyers finally returned to the spot markets following the first of the year, lifting prices off the $1.30 level—a level which many deemed a “good value” buy. Renewed confidence kept nearby milk prices from breaking below a critical, long-term support of $13.00 and gave the Class III futures price a much-needed bounce higher.

Also during the first week of the year, the bi-weekly Global Dairy Trading event saw a jump in powder prices ranging from 10%-20%. This jump was largely attributed to weather problems in the Oceania region, which limited gains in milk production (compared to last year). As a result, Dry Whey and NFDM futures broke into new high prices and have been extending gains. USDA describes domestic supplies of these products as “adequate,” while supplies remain tight in some local areas.

Cold storage inventories continue to show slashed butter stocks, and after a brief set back to $1.80/pound, spot butter price moved back to $2.10/pound on the CME to further encourage production. Between the developments of powders and butter, Class IV prices quickly strengthened and processors saw strong margins for these products.

In response, cheese prices needed to rise simply to compete for available milk. Cheese futures contracts made the first move by jumping 10 cents in two weeks to raise the six-month forward average from $1.50 to $1.60/lb. Naturally, this fueled the first major jump in Class III futures for 2011. In addition, Block and Barrel spot cheese prices broke over the pivotal $1.50 level, propelling further gains in the first and second quarter prices.

It is also noteworthy that the bullish grain reports on Jan. 12 have supported milk prices. By the week ending Jan. 28, the milk complex finally seemed content to slow down, at least for a day or two. Both powder futures and Class III prices backed off the highs from earlier in the week in consolidating price patterns. The result, as mentioned in the beginning, is the strongest four-week move higher we’ve seen in Class III prices since April 2007.

So what’s next?

In short, with how dramatic this run up has been, a correction lower is a reasonable expectation. However, prices could continue to sprint higher, for several reasons having to do with cheese. The spot cheese price has done a great job of coming up to the level of our February and March milk futures price. Now that these are more in line with each other, any increase or decrease in cheese should be reflected in the milk price for February and March, because of the way the Class III formula is calculated.

For the rest of 2011, prices have started to signal a correction is likely due. As we analyze this cycle, a sideways price pattern would give the most supportive look to the price charts. A pull-back of 50 cents to $1/cwt., however, is a realistic possibility. For example, the May contract closed last Friday at $16.75 and could come back down as low as the $15.50 area, which is long-run support and the breakout point for this explosive move higher.

I’ve been pleased to talk with many dairy producers who are anxious to use this rally to either start hedging their 2011 milk or add to their current positions. I would agree that now is a great time to implement the right strategy. The challenge many are recognizing is that the recent volatility has inflated option prices, making it cost prohibitive to simply buy Put options or use Call options to complement forward contracts at the milk plant.

Milk is not the only market with this issue. The grain markets have been dealing with this issue of high option costs for months. Our grain clients, however, have found that it is possible to get attractive option strategies in place. I would offer two pieces of advice to address this issue.

·Learn about and look at more advanced options strategies. These could include Fence Positions (Min/Max) or Bear Put Spreads for downside coverage, or a Bull Call Spread for re-ownership positions. If you have a good understanding of basic options, these strategies are not difficult to grasp.

·Secondly, and especially when using advanced option strategies, it is critical to understand how any marketing decision will impact your overall milk price. Specifically, how much will a given strategy help your price if a new downtrend occurs, and how much would it limit your upside potential if prices can continue to rally higher? You may be surprised how some strategies will be more or less effective to your overall price than they initially appear. A little time invested in Market Scenario Planning will help you see the benefits of each strategic choice.

The only thing not to do is “wait and see what happens.” I continue to encourage producers to evaluate the opportunities at hand and to make an informed decision whether it is the right time for you to engage the milk market. Understanding how your decision will play out in any market development will give you the confidence to make the decision that puts your dairy in the best position to succeed. If January’s volatility has had you less than confident, you do not have to spend the entire year feeling that way. Take steps to take back some control and build your best possible weighted average price for 2011.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2011 Stewart-Peterson Inc. All rights reserved.

What does it do? This dairy insurance policy manages the risk of falling milk prices and rising feed costs.

LGM products can be tailored to a wide range of dairy operations. These products are bundled options that insure the producer’s gross margin over the period of insurance. LGM for Dairy is a package, like bundled options -- you have a corn call, a soybean meal call and milk put bundled together with no off-setting CME or CBOT transactions to create market shift.

When compared to options, LGM may be a better fit since options cover fixed amounts of commodities, and those commodity contracts may be too large for risk management strategies for some dairies.

What is the Margin?

Your Expected Gross Margin (insurable margin) is the average price of milk (in hundredweights) that you choose to insure, minus the average price of corn and soy meal times the tons of corn and soy meal you choose to insure. The average of the milk, corn and meal closing prices from Wednesday, Thursday and Friday, prior to sales day, is used in the estimated insurable gross margin calculation.

When Can I Buy LGM for Dairy?

LGM for Dairy insurance is offered for purchase at the end of each calendar month on the last business Friday. (The next sales day opportunity is Jan. 28, 2011.) You can insure one month or a combination of months up to 10 months each sales day.

The window of time for purchase is fairly short since USDA’s RMA reviews the market data for milk, corn and soybean meal after the close of markets on the last business Friday (sales day) of the price discovery period and the sales period ends Saturday.

Preparation for participation includes knowing a reasonable estimate of your expected cost of production, calculating feed needs for the insurance period and estimating monthly marketings of milk. You do not have to insure all of the milk you expect to produce for a given month at one time. You can insure a percentage of each month’s production several times throughout the year. The maximum insurable production is 240,000 cwt. or 24 million pounds in each crop year. A Federal Crop Insurance year runs from July 1 through June 30.

Paper work is limited but be prepared to pay the insurance premium at the end of the policy period. The premium goes into a pool held by RMA for payment of indemnity. Your premium is subsidized if you insure two or more months and the percentage of the premium subsidized increases from 18% to 50% as you select higher deductibles.

In future editions of Dairy Today eUpdate, we will take a closer look at the details of LGM for Dairy.

I have very rarely shared my opinion in this column over where I think the market is going to go. I have done so intentionally, as I wanted readers to focus on the mechanics of how futures and options work. In this last column, I will break from that tradition.

By Jon Spainhour
Rice Dairy

Over the last 12 months, we have discussed many different issues that dairymen have to think about when it comes to using financial tools like futures and options to hedge their input and output prices for their dairy operation. It has been my hope that dairymen have been able to read these articles and come away with a better understanding of these issues than before.

While many of these issues and topics can seem very complicated at first, like puts and calls, I can assure you that if you remain committed to learning about them that they will easily become part of your day-to-day operations and you won't want to run your business without them.

This column will be my last column, as I will be passing off to my colleague Katie Krupa. She will be writing to you in the same spirit as I have, in hopes to shed light on what many people see as an overly complicated subject. I have enjoyed sharing my thoughts with you over the last year and I know you will enjoy hearing hers.

I have very rarely shared my opinion in this column over where I think the market is going to go. I have done so intentionally, as I wanted readers to focus on the mechanics of how futures and options work. I will break from that tradition slightly in this article and say that I believe that 2011 is going to be year of high dairy prices.

We are already seeing the protein and fat prices move to levels that we haven't seen in several years, and it won’t be long until the cheese price follows. Ultimately, I believe prices are still going higher than current levels and that overall milk prices will be much better this year than last.

While I am sure that most people are happy to hear that, I also think that we need to point out a few things. To begin with, grain prices are shooting higher as well, and that means that producers should remain committed to hedging their input prices. We have spoken several times in this column about the dangers of hedging your grain without hedging your milk. Don't lose that discipline. Make sure you are buying on your milk while you are hedging your grain. Anything can happen, and the last thing we want is to have hedged our grain and not our milk and have both prices suddenly drop.

Also, we need to keep in mind that one of the reasons that milk prices are moving higher is because of the export market. We are sending more and more of our product overseas, and while that is a wonderful thing, it also can be full of volatility. Export markets can be jumpy, and when you are a so reliant on them to keep your price higher, small hiccups in export demand can push domestic prices lower quickly. Simply because the price of milk is going higher, doesn't mean that it has to stay there. Make sure you are buying puts and taking advantage of these higher prices.

Finally, we are likely going to see production in this country and around the world expand dramatically in the next year or so. Many people will argue with me, but I think we will see it happen. If that is the case, we will see more milk that could weigh on prices. I think that can be handled by using risk management tools as well. However, if you are going to expand your herd, make sure you refigure the amount of milk and grain that you need to hedge.

All in all, I think it is going to be a great year for producers, but I hope you take advantage of it. It has been a pleasure writing for you and I hope you feel more comfortable with risk management topics than before.

Jon Spainhour is a broker/trader with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. You can reach Spainhour at jcs@ricedairy.com.Visitwww.ricedairy.com.

A common question is, “Why didn’t dairy producers use the milk marketing tools that were available to them to manage their milk price risk?” The answer is easy. They have not had commodity market education.

By Carl Babler
First Capitol Ag

First Capitol Ag has accepted the invitation to author a series of columns for Dairy Today eUpdate. Our goal in these upcoming columns is to share with readers key milk marketing principles and common traits held by successful milk marketers we have worked with and observed from our position as commodity brokers in the dairy markets.

We look forward to presenting a number of topics that range from simple commodity marketing definitions all the way through comprehensive structured risk management approaches that focus on managing dairy net margins.

To start the process, we want to highlight what we have found to be a critical requirement for commodity marketing success: education.

Recently those inside the dairy industry, and those outside looking in, have observed dairy market conditions and commodity price volatility negatively impact a dairy producer’s bottom line. Stories abound detailing operational losses, equity burn, and inability to service or secure debt as a result of low milk prices.

The lament of “I woulda, shoulda, coulda done something with milk price” is common as many producers endure financial hard times. A common question is raised: “Why didn’t dairy producers use the milk marketing tools that were available to them to manage their milk price risk?” The answer is easy. They have not had commodity market education.

Consider the role of market education in the case of dairy producers. Producers have discussed commodity markets, watched milk price, read about marketing tools, attended one-day workshops, and received recommended marketing strategies. Well-intended lenders and agribusinesses who serve dairy businesses encourage dairy producers to use price risk management. Awestruck dairy producers want to use dairy marketing tools, but where education is lacking, confusion takes place, leading dairy producers to inactivity.

In this time of extreme financial pressure, milk price volatility and uncertainty in the dairy industry, an unprecedented appetite has surfaced for milk-price risk management strategies and solutions. The reality is that without education, the strategies and solutions available to producers will go unapplied again.

As instructors of a comprehensive commodity marketing course covering market principles, price behavior, the mechanics of cash and futures markets, along with the marketing tools and the strategies for applying the tools, we at First Capitol Ag have observed dairies around the country that have put a high priority on education and dairy price risk management.

The understanding of risk management does not happen overnight. We have observed that most dairy businesses spend three to five slowly adopting new tools before their management culture changes toward consistently acknowledging risk and applying management strategies. These dairies openly acknowledge that formal commodity market education has been essential in their successful development and launch of a beneficial milk marketing plan. These engaged dairies also resist the argument that “commodity marketing is to complex for a dairy producer to understand” and that “dairy producers do not have the time to direct the marketing for their milk.”

Tools are available in the cash and futures markets to manage earnings volatility.

Education is required for dairy producers to understand and strategically apply these risk management tools. Education is thus available. It is the critical bridge to apply dairy marketing, seek it out.

We at First Capitol Ag are committed to do our best over the next months to provide, via this column, commodity marketing learning opportunities relative to dairy markets. Openly admitting that we are still learning ourselves, we look forward to learning with you during this upcoming year.

Carl Babler is Senior Hedge Specialist with First Capitol Ag in Galena, Ill. You can reach him at 800-884-8290 or cbabler@firstcapitolag.com.

“Expect milk price volatility.” Are you getting sick of this line yet? In the discussion of milk prices, whether it’s in a printed article, with a speaker or in conversation with your neighbor, I can just about assure you that price volatility is one of the first topics. However, I personally find the phrase, “expect volatility” to be a vague statement. It’s similar to saying something like, “It’s going to snow.”

An inch? A foot? It makes a big difference, especially in how you prepare and plan for such weather.

Many dairies I work with continue to put together their 2011 budgets and have asked me what to plug in for a milk price. The simple answer is the price that the Class III futures are trading, since, based on everything we know today, that is the price that milk buyers and sellers can agree on. However, using some basic historical analysis, we can see that it is not very likely that the prices on the board today, even as close as six months away, will actually materialize.

Of course, any time we use historical data it is important to recognize that what happens in the future is seldom a carbon-copy of history. We can use history as a guide, however, as to “how much” volatility to expect.

Six months from now, June 2011 will be the front month milk contract. On Dec. 15, 2010, the closing price for that contract was $14.62. Looking back over the previous 10 years, what type of change from that price could we expect between mid-December and the actual June milk price? The results are pretty interesting.

Since 2001, in five of those years, the June price rallied, and in five of those years, the price declined. On average, the change was a gain of 94 cents/cwt. However, this average is misleading, and here’s where volatility really comes into play. In eight of the past 10 years, the final price was at least $2.00/cwt. different than in December of the previous year. In fact, in years when prices rallied, the average gain was $4.25/cwt., while in years when prices declined the average loss was $2.35/cwt.

Needless to say, these are sizable changes. What this discrepancy shows us is that small and unpredictable changes in the supply/demand balance, both domestically and globally, can have a dramatic impact on your mailbox price. (Economists call this “Price Elasticity”--the analysis of changes in supply or demand relative to price.)

This is not to say the prices that appear on the board of trade are unreliable. As we mentioned, market participants are using the best information available today to arrive at a fair price. As milk hedgers, the marketplace gives you the opportunity to move risk away from your price instead of seeing the big changes.

So, if recent history suggests that prices could move $2.00/cwt. from $14.62, do we actually think that both $12.62 and $16.62 are potential final prices for June 2011? Absolutely. In either case, the right series of fortunate or unfortunate events needs to take place, and each of us may have a different opinion of which is more likely to play out.

What to do now?

Preparing for uncertain weather—such as how much snow or rain we will get—offers a good analogy to preparing for uncertain markets. In that light, a British adventurer once said, “There is no such thing as bad weather, only inappropriate clothing.”

In other words, if you are prepared for the weather, you’ll weather it better.

Similarly, our advice to clients is not to judge the good or bad of what is happening in the market, or try to predict it. Rather, always have your operation prepared for both scenarios:

·If prices continue to trend up, you’ll use Plan A. We see $16.42 (or generally higher prices) for next year if exports can continue to be strong and domestic cheese inventory growth remains at a moderate pace.

·If prices start to trend down, then use Plan B. Milk-per-cow has been very strong over the last year, and a moderate increase in cow numbers could result in heavy milk production growth, resulting in slumping prices.

These plans can be as simple or complex as you’re comfortable with, based on the tools in your marketing toolbox.

From everyone at Stewart-Peterson, we’d like to wish a Happy New Year to you and your family. While the past several years have been challenging to those in the dairy industry, we’d like to wish your operation the best success in 2011. As for our forecast: Expect volatility. And be appropriately prepared.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2010 Stewart-Peterson Inc. All rights reserved.